Ricky Valianto Adiputro S1375342
“Equity Crowdfunding: Signaling in European Crowdfunding Platforms”
Master Thesis
Key words:
Crowdfunding
Equity Crowdfunding Signaling Theory
Information Asymmetry Alternative Financing Entrepreneurs
Supervisory Committee:
Dr. Xiaohong Huang Dr. Henry van Beusichem
ACKNOWLEDGEMENT
It has been an honor to do my education from the start of my Bachelor until my Master study at University of Twente, the Netherlands.
Prior finishing this master thesis at financial department, I would like to express my highest gratitude to dr. Xiaohong Huang who has been my first supervisor since the beginning of my master thesis. Her quality feedbacks, guidance, and comments have been highly valuable for me in writing this thesis.
Furthermore, I would also like to express my highest appreciation for dr. Henry van Beusichem as my second supervisor for his feedbacks.
Finally I would like to thank my family, friends, and fellow students who have been supportive and encouraging.
ABSTRACT
This paper investigates the types of information that could be identified as signals to influence investors’ decision to invest in private equity financing through equity crowdfunding platforms. As an expanding topic, little is known which type of information could be conveyed as signals to investors through limited means of communications. The study involved sample from multiple equity crowdfunding platforms across Europe. The relationship between each type of signal and level of funding success in equity crowdfunding was empirically tested using binary logistic regression and ordinary least square regression analysis. Empirical results showed the importance of social networks and human capital. On contrary to prior prediction based various academic paper in other type of private equity financing, variables of intellectual properties, financial information, and other information did not provide conclusive results.
Abbreviations
CF Crowdfunding
CFP Crowdfunding Platform EC Equity Crowdfunding
ECP Equity Crowdfunding Platform VC Venture Capitalist
VCF Venture Capital Financing
ESMA European Securities and Markets Authority
List of Figures and Tables
Figure 1: Relations between stakeholders 12
Figure 2: Level of risk 15
Figure 3: Relationship of variables 26
Figure 4: Sector classification 43
Table 1: Definitions of variables 41
Table 2: Sample Size 42
Table 3: Descriptive statistics 44
Table 4: Pearson’s correlation matrix 47
Table 5: Colinearity statistics 48
Table 6: Binary regression 49
Table 7: OLS regression 50
TABLE OF CONTENT
CHAPTER 1: INTRODUCTION! 8!
1.1! BACKGROUND AND PROBLEM STATEMENT! 8!
1.2OBJECTIVE! 9!
1.3FINDINGS! 10!
1.4CONTRIBUTIONS! 10!
1.5STRUCTURE! 11!
CHAPTER 2: THEORETICAL BACKGROUNDS! 11!
2.1CROWDFUNDING! 11!
2.1.1CROWDFUNDING: AN INTRODUCTION! 11!
2.1.2TYPES OF CROWDFUNDING! 13!
2.1.3FINANCING PROCESS IN EQUITY CROWDFUNDING! 15! 2.2EQUITY CROWDFUNDING MARKET: A EUROPEAN PERSPECTIVE! 16!
2.2.1CROWDFUNDING AND SPATIAL DISPARITY! 17!
2.3INFORMATION ASYMMETRY! 18!
2.4THE THEORY OF SIGNALING! 20!
2.4.1DEFINITION! 20!
2.4.2SIGNALING IN PUBLIC EQUITY FINANCING! 22!
2.4.3SIGNALING IN VC FINANCING! 23!
2.4.4SIGNALING WITHIN EQUITY CROWDFUNDING! 23!
CHAPTER 3: HYPOTHESIS DEVELOPMENT! 25!
3.1INTELLECTUAL PROPERTY! 26!
3.2HUMAN CAPITAL! 28!
3.3SOCIAL NETWORKS! 30!
3.4FINANCIAL INFORMATION! 33!
3.5OTHER NON-FINANCIAL INFORMATION! 34!
CHAPTER 4: METHODOLOGY AND DATA! 36!
4.1STATISTICAL METHODS! 36!
4.2MEASUREMENTS OF THE VARIABLES! 37!
4.2.1DEPENDENT VARIABLES! 37!
4.2.2INDEPENDENT VARIABLES! 38!
4.2.3ADDITIONAL VARIABLES! 40!
4.3DATA COLLECTION! 42!
CHAPTER 5: RESULTS AND DISCUSSION! 44!
5.1DESCRIPTIVE STATISTICS! 44!
5.2REGRESSION RESULTS! 51!
CHAPTER 6: CONCLUSION, LIMITATIONS, AND RESEARCH DIRECTION! 56!
6.1CONCLUSION! 56!
6.2ACADEMIC AND PRACTICAL IMPLICATIONS! 58!
6.3LIMITATIONS AND SUGGESTIONS FOR FURTHER RESEARCH! 58!
REFERENCES! 60!
APPENDIX! 68!
!
Chapter 1: Introduction
1.1 Background and Problem Statement
Young ventures go through several stages of financing, typically starts with funds from entrepreneurs’ own money and business angels (Wilson, 2001) to bank loans, venture capitalist, and public equity financing through an IPO. Studies show (e.g. Turan, 2015a; Turan, 2015b) that it becomes increasingly difficult for young ventures to obtain outside financing including banks and venture capitalists (VC). The demand for alternative source of financing has been on the rise in past years, especially in post-2008 financial crisis after which VCs tend to be more selective in investing in small young ventures. In addition, many governments are found to have reduced their subsidy for small businesses in order to cope with their high-accumulated governmental debts (Bielefeld, 2009; Ferrera, Hemerijck, Rhodes, 2011; Lehner, 2011). Some literatures argue crowdfunding could fill in this financing gap. Crowdfunding is an emerging alternative source of financing that has been gaining an increasing popularity both practically and academically in past couple of years (Gierczak et al., 2016). The main idea of crowdfunding is to pool money from a broad audience through integrated online platforms in return of certain rewards (Schwienbacher and Larralde, 2010). With the introduction of crowdfunding, more affordable and accessible funds are available from a combination of a large group of professional and amateur investors (crowd) through online platforms to reduce the funding gaps between early and later stage of venture financing Belleflame, Lambert, Schwienbacher (2014).
Crowdfunding is typically categorized into reward-, donation-, lending-, and equity-based. There has been an immense growth as reported by Massolution, a consulting firm, in which funds raised in worldwide crowdfunding platforms bolstered by 167% in 2014 and valued at $16.2 billions from $6.1 billions in previous year (Massolution, 2015). The financial value is expected to keep increasing for foreseeable future. Massolution (2015) further reported that the US still holds the largest market share for crowdfunding, while latest figure show EU is the second. Report form European Commission (2015) stated that total value of crowdfunding markets in all EU stood at
€4.2 billion, of which €4.1 billion raised for crowdfunding categories entailing financial returns (loan-, and equity-based).
The relevance of equity crowdfunding research as an academic topic grows simultaneously with its increasing popularity in practice. Equity crowdfunding and public equity financing work in similar manners. The central differences are the medium to which both work, the types of
investors, regulatory level. For investors, the worst default risk is total loss of their investments.
Thus investors need to assess the default probability of their investment portfolio. In order to estimate the risk, investors need to cultivate all information necessary that would mirror the quality of their (potential) investment. However asymmetrical information arise between investors and companies, as top management team of the company is always assumed to hold superior knowledge about their own company’ quality relative to investors (Stiglitz, 2002). In public equity financing, investors are better protected and companies’ information disclosure is tightly regulated (Kreps, 1990). Yet, information asymmetry remains a big concern, and subsequently clearing paths for financial and information intermediaries such as banks and news agencies to be involved (Kreps, 1990). On contrast, in private financing for small ventures in particular, the availability of such financial intermediaries is often vacated and information disclosures are often not required by laws (Butler, Kraft, and Weiss, 2007). The nascent nature young ventures and the absence of critical information for investors to assess the probability of the default risks of their (potential) investments, making investing in young small ventures particularly riskier. To minimize the risk of investing in private equity financing such as venture capital financing, both venture capitalist and ventures typically undergo several arduous screening process or contract negotiation (Moritz and Block, 2016). However these options are not available through online equity crowdfunding platforms.
One other solution to address information asymmetry issue, entrepreneurs and management teams can send signals about their companies’ quality to (potential) investors (Connelly et al., 2011).
There have been extensive amount of research directed at signaling between companies and investors in public equity financing (e.g. Amir and Lev, 1996; Certo et al., 2003; Cohen and Dean, 2005) as well as private equity financing such venture capital financing (e.g. Audretsch, Bonte, and Mahagaonkar, 2012; Baum and Silverman, 2004). However, as a relatively new topic, signaling topic has not been put in much regard in equity-based crowdfunding (Moritz and Block 2016). The simultaneous growth of equity crowdfunding in many countries as well as the increasing needs for young ventures to find alternative sources of financing will make equity crowdfunding a particularly interesting case.
1.2 Objective
The very few existing empirical literatures concerning investors-entrepreneurs relationship in equity-based crowdfunding has prompted my interest for conducting research in this field. The objective of this research is to find which signals that trigger investors to invest in ventures with virtually limited information though online equity-based crowdfunding platforms. Identifying
relevant signals that are affecting investors’ decision is believed can make valuable contribution on this continuous-growing alternative financing method though online crowd. Thus in order to conclusively answer the intended objective of this research, the following research question is formulated:
“What ventures’ signals in equity crowdfunding platforms influence investors’ decision to invest?”
1.3 Findings
The paper investigates the types of information, which could potentially facilitate investors’
decision to invest through equity crowdfunding platforms, measuring variables of intellectual property, human capital, social networks, financial information, and other non-financial information which were not previously studied in specifically in crowdfunding platforms.
Empirical results confirmed social networks and human capital to be most influential factors.
While other variables of intellectually property, financial information, and other non-financial information, which have traditionally considered as important in other types of financing did not show conclusive results.
1.4 Contributions
Signaling theory has been extensively studied many fields including public equity financing and venture capital financing. However there is very limited studies covering signaling theory in equity crowdfunding context. This study contributes to academic and practical research in the following manners. Firstly, a large share of research dedicated to equity crowdfunding has been focusing on the process, regulations, and its potentials (Moritz and Block, 2016). To my knowledge currently there are only 2 papers studied signaling in equity crowdfunding topic.
Vismara (2016) extended his researched on regulations role for equity crowdfunding and signaling roles towards equity retention and social capital. While Ahler et al. (2015) gave higher attention to signaling theory itself using an early set of data from Australian-based equity crowdfunding platform. Thus this paper will supplement both papers by providing a wider set of variables and expanding our understanding of quality signals that ventures can provide through limited interactions in online platforms. Second this paper elucidates the potentially crucial effects of online attributes of social media, in addition to other attributes including human capital and intellectual properties to stimulate crowd’s investments. Subsequently this paper explicates academics and practical implications online financing for entrepreneurs, investors, and academia.
1.5 Structure
The rest of the paper is structured as follows. A theoretical background is developed by firstly introducing crowdfunding in general, which is followed by critical review of the concept of information asymmetry and signaling. Subsequently, I will go further by developing hypothesis from related existing literatures. The next chapter presents statistical methods of the study, measurement of the variables, and data collection. Afterwards, I will exhibit the empirical results along with discussion. The following chapter will end the paper with conclusion, limitation of the research, and direction and recommendation for future research.
Chapter 2: Theoretical Backgrounds
Chapter 2 is divided into 3 different parts. The outset of this chapter introduces the concept of crowdfunding in general and equity-crowdfunding in detail. It will be followed by how the financing process in equity-crowdfunding works, and current condition of equity-crowdfunding market in Europe and cross-border transaction between EU countries. The second part discusses the core issue of the topic, information asymmetry between investors and ventures. While the last part discusses the concept of signaling.
2.1 Crowdfunding
2.1.1 Crowdfunding: an Introduction
The idea of crowdfunding originated from various concept of financing, including crowdsourcing (Poetz and Schreier, 2012) and micro-finance (Morduch, 1999). Although the idea of collective fundraising from big crowd to finance a project has been around from sometimes, the application of Web 2.0 allows it to develop in a more unique way that a transversal way of interaction between investors, entrepreneurs, and technological platforms could create values for all involved parties (Danmayr, 2014; Nasbaradi, 2016; Ordanini et al., 2011). In linear to the growing number of websites devoted to crowdfunding, the concept has captured significant interests in recent years by scholars. As a relatively new and evolving topic, the conception of the word
‘crowdfunding’ is particularly limiting and elusive (Mollick, 2014). For simplicity purpose, this paper follows broad definition of crowdfunding as defined in one of the early research of the topic by Schwienbacher and Larralde (2010) who stated crowdfunding as:
“An open call, essentially through the Internet, for the provision of financial resources either in form of donation or in exchange for some form of reward and/or voting rights in order to support
initiatives for specific purposes”
This particular definition has been mentioned in various crowdfunding papers, nonetheless as Mollick (2014) argued, the expansive definition of crowdfunding proposed by Schwienbacher
and Larralde (2010) could still potentially count out what some scholars in other fields exemplified and labeled as ‘crowdfunding’ such as fundraising in music industry that was initiated by fans (Burkett, 2011) or internet-based peer-to-peer lending (Lin, Prabhala and Viswanthan, 2013).
As an alternative financing, the aim of crowdfunding is to gather a large group of people (crowd) with a combination of individual professional or amateur investors and organizations, to raise enough money to finance a project or new venture through online social platforms instead of raising money exclusively from professional and institutional investors (Belleflame et al., 2014).
There are three main stakeholders involved in the crowdfunding process namely the financial backers (investors), financial seekers (entrepreneurs, startups, individual/organizational project initiators, and/or artist), and crowdfunding platforms. Often, the backers and seekers involved are limited to private individuals instead of institution (Mollick, 2014). Albeit it is varied in different types of crowdfunding, especially equity crowdfunding where financial seekers are young ventures (Gerber et al., 2012; Verstein, 2011). Additionally, the exponential growth of funds raised through crowdfunding platforms along with simultaneous legalization of equity crowdfunding in many countries such as the JOBS Act in the US (Belleflame et al., 2014) and in UK, France, Germany and other EU countries (European Commission, 2016) have attracted the involvements of many profit and non-profit organization (Mollick, 2014; Schwienbacher and Laralde, 2012). For consistency purpose, bearing in mind the nature of this research, I will use the term ‘entrepreneurs’ for financial seekers and young ventures, as well as ‘investors’ for financial backers the rest of the paper. The relationship between these three stakeholders can be descriptively illustrated in the following figure:
Figure 1. A Framework of relations between three main stakeholders (Adopted from Valanciene and Jegeleviciute (2014))
Crowdfunding platforms merely act as an intermediary between ventures and investors. In contrast to banks and venture capitalist, platforms do not lend or invest in the ventures or projects.
Although some similarities between crowdfunding platforms and venture capitalist emerge, especially equity crowdfunding platforms, as more platforms get more involved in screening and evaluating process ventures prior funding campaign. There are four types of crowdfunding platforms. Each is categorized based on the type of returns that investors will receive. The subsequent part delves further into it.
2.1.2 Types of Crowdfunding Rewards-based
In reward-based crowdfunding, financial returns are not the main objective of investing. Investors do seek rewards in returns as a primary motivation to participate, but in form of tangible returns instead of financial returns (Kuppuswamy and Bayus 2013; Gerber et al., 2012). The degree of rewards that investors received varied in accordance to their perspectives, and it is rather difficult to draw a precise dividing line between what are considered rewards or not to investors. This due to the rewards often being tailored-made depending on the amount of the contribution. Belleflame et al. (2015) gave an example video game case in which rewards could come in form of a personalized game, or simply a copy of the game.
Donation-based
Similar to reward-based crowdfunding, investors in donation-based crowdfunding are not expected to receive financial rewards or stake in the project in returns. However investors act in a charitable manner to a particular project in order to unpretentiously contribute in achieving a certain result to community (Gierzczak et al., 2016). Belleflemme et al. (2015) pointed out that investors are regarded as philanthropists and their voluntary contributions are compensated in form of community recognition. Donation-based crowdfunding platforms, due to its nature, quite often act as intermediaries for non-governmental organization and charities although still charge a certain percentage of the contributions pledged to the projects once the projects have been successfully funded (Belleflemme et al., 2015; Lehner, 2013).
Lending-based
Contrast to reward-based and donation-based crowdfunding, the primary motive of investors in lending-based crowdfunding is to receive financial returns. Returns are usually offered in form of percentage had the project been successful. Funds offered here is in form of loans similar to that of banks (Mollick, 2013). The distinctions between lending-based and traditional banks, lay in the
role of the platforms as they do not screen projects but let investors judge with the decision. In addition to the patronage model elements of investors that could be included where investors’
interests might be skewed towards social goods boosted by the venture instead of purely financial motive (Belleflemme et al., 2015; Mollick, 2013).
Equity-based
Equity crowdfunding (EC) or also sometimes called crowdinvesting is a type of crowdfunding where businesses make an open call to attract investment from investors in crowdfunding platforms, in returns of a certain amount of bond or equity-like shares (Mollick, 2013). Unlike other types of crowdfunding such as donation-based where ‘investors’ simply donate their money, EC requires a more extensive legal basis and in many countries the legality of EC has not been explicitly regulated (Hagedorn and Pinkwart, 2016). Although works in the same manner as public equity financing, the main differences are the role of the platforms, the much smaller size of investments, and the type of investors involved. Investors involved can be both amateurs and professional, whereas investment size can be as little as €10 depending on the platforms (Bellefleme et al., 2015). EC platforms intermediated transaction between entrepreneurs and investors by providing standardized legal contract, settling the transaction, and screening and evaluating both parties involved (e.g. requirement of only accredited investors allowed in some EC platforms, the standardized information that should be provided about the ventures, etc.) The following figure illustrates the different risk associated with each stakeholders involved in EC.
Similar as in traditional public equity financing and venture capitalist, one of the prime risks is different information that entrepreneurs and investors have. Entrepreneurs as ‘insiders’ arguably posses more information about their ventures. However, investors as the ‘outsiders,’ are expected to posses less information, which would increase their risk. More about informational differences between investors and entrepreneurs will be further discuss in the later part of this chapter.
Figure 2. Level of risk associated to each stakeholder in equity crowdfunding process (adopted from Turan (2015b)).
2.1.3 Financing Process in Equity Crowdfunding
Investors are shown to face the highest risks. Subsequently, to make it more attractive for investors to invest, crowdfunding platforms often act as venture capitalist especially prior the start of the financing campaign. While in VC financing, venture capitalist as the potential investors have flexible choices of communication with their potential investments directly, investors in equity crowdfunding are typically only able to communicate through the online platforms with limited data as presented in through the platforms. Hagedorn and Pinkwart (2016) constructively designed the financing process in equity crowdfunding. The process is divided into seven phases;
application, screening and selection, contracting, roadshow, subscription, holding, and exit (Hagedorn and Pinkwart, 2016). The first four phases involve only ventures and platforms, when platforms receive the application of ventures in forms of documents that are obligated to be presented in the campaign (roadshow) stage, evaluate these offerings and future values, and select which ventures pass on their criterion. The next stage involves negotiating any terms and conditions for both parties until a contract is signed (Hagedorn and Pinkwart, 2016).
Subsequently, ventures begin their financing campaign through the platforms for a fixed period of time agreed in the contracting phase. This phase is the most crucial phase it oversees the involvement of potential investors for the first time. ‘Roadshow’ phase is also crucial as it is the only window where ventures can raise capital, thus heavy marketing activities are also involved (albeit very limited compare to public equity financing). Most equity crowdfunding platforms adopt a threshold-pledge-system (Hemer et al., 2011) during this phase, in which a minimum set
amount of investment is required within the campaign period. Consequently, if a threshold agreed upon is not met until the financing campaign ends, the invested shares will be cancelled thus investors would receive their money back. The next phase deals with contracts between investors and ventures regarding the holding of the shares. Contracts can be varied depending on the ventures and how it is regulated in each country. The next phase are holding phase, in which investors are shareholders of the ventures, and exit phase where investors exit the invested ventures. However Hagedorn and Pinkwart (2016) stated it is too early to provide any empirical data for the last two phases. There are also no literatures that studied equity crowdfunding after the financing campaign is finished.
2.2 Equity crowdfunding Market: a European Perspective
I introduced crowdfunding in general, equity-crowdfunding and its financing process, this part deals with the more relevant theoretical background in relation to the problem statement. An empirical research conducted by Agrawal et al. (2011) using Amsterdam-based crowdfunding platform Sellaband found investors involved to be from continent-wide. Report published by European Commission on ‘Crowdfunding in the EU Capital Market Union’ mentioned that cross- border funding is in someway limited, though on the other hand they also found a large degree of funds from UK-based ECPs come from outside UK (European Commission, 2016). This limitation could be due local regulator that favors the needs of local investors and market, albeit European Commission is favoring closer integration of regulatory approaches within EU by setting up European Crowdfunding Stakeholder Forum (ECSF). Legal regulatory of crowdfunding is developing simultaneously with its growth, European Commission stated only 7 EU members have explicitly introduced legal frameworks for CF activities while several other members are planning to introduce it as 2016. In addition, European Commission documented an increase in values of equity-based campaigns within all EU countries, with total funds raised at
€422,039,462 from 836 campaigns in 60 ECPs (European Commission, 2016).
European Commission further reported a jumped in funds raised through crowdfunding involving financial returns within EU to be € 4.1 billion in 2015. European Commission recorded the number of CFPs operating within EU member states to be 502, of which reward-based CFP represents the majority of 30% followed by equity-based (23%) and loan-based (21%).
Specifically for equity-based crowdfunding, the UK leads among other EU countries measured by total fund raised followed by France, and Germany between 2013-2014 (European Commission Report, 2016). While EU-wide growth in EC markets reached 167% within the same period.
2.2.1 Crowdfunding and Spatial Disparity
European Commission reported cross-border transactions between EU countries have been increasing in crowdfunding in general. Compare to VC financing, crowdfunding has the potential to eliminate distant-related issues usually limiting small ventures seeking financing from VCs.
Researches on venture financing topic including Sorenson and Stuart (2001) found that investors in early venture financing tend to be local, while distant investors are more commonly found in publicly traded firms. One of the reasons is while in traditional equity financing investors provide financial inputs; VCs’ roles in venture financing further include providing strategic and operational issues and generally act as management consultant (Bygrave and Timmons, 1992). As the result, Sorensen and Stuart (2001) found VCs spend considerable amount of time for monitoring their portfolio companies as post-investment activities that require frequent visits, thus favoring spatial proximity of their portfolio companies. On the other hand, crowdfunding greatly reduced the needs for spatial proximity between investors and entrepreneurs by eliminating some distance-sensitive costs, as suggested by Agrawal et al. (2011). Same research by Agrawal et al. (2011), which was conducted in crowdfunding in Music industry, found that the average spatial distance between entrepreneurs (artists in Agrawal et al. (2011) study) and investors stood at 5000 km, suggesting that proximity effects as in Sorenson and Stuart’s (2001) study on VCs financing to be significantly reduced. One important note that Agrawal et al. (2001) used Amsterdam-based CF as their sample, while investors are found to be in other continents as well, a large number are local Dutch investors. Some functions of CFPs have allowed a wider spatial disparity between investors and entrepreneurs. Nonetheless, though the need of physical interaction is reduced, investors still pose the highest risk when investing in equity crowdfunding (figure 2). The wider spatial disparity in ECF, compare to the traditionally closer distance between investors and ventures in VC financing, increase the information gap between both parties as the means of communication is fairly limited.
The following sub-chapters delve into the core problem of this paper, which is to identify types of signals that influence investors’ decision to fund entrepreneurs’ through CFPs. Firstly exploring the concept of information asymmetry that exist, followed by introduction of the theory of signaling.
2.3 Information Asymmetry
Information is used by individuals in businesses, households, and governments or at virtually any levels of activities that involve decision-making process. Some information is available publicly and some are obtained privately. The occurrence of information asymmetry is the result of different people involve in the same process but posses different knowledge (Stiglitz, 2002).
Information asymmetry can occur in all decision making process. In capital market, Akerlof (1970) greatly illustrated the concept of information asymmetry by what he called ‘lemon law’. It states that investors are unable to appropriately distinguish companies of ‘low’ qualities and those of ‘high’ qualities (Akerlof, 1970).
To understand the concept of asymmetrical information, Stiglitz (2000) first differentiated two types of information. The first one deals with information about quality where one involved party is not fully aware about the value and characteristics of the other (the companies). The second type put regards about the intent of the information, as one of the involved parties is questioning the other’s behavior and intention of their behavior (Elitzur and Gavious, 2003; Stiglitz, 2000).
The first one is also known ‘adverse selection’; the true value and characteristics of the companies do not change after the transactions between entrepreneurs and investors. While for the later also known as ‘moral hazards’, the value might change (Kirmani and Rao, 2000). Both types of information asymmetries are solved by different methods (Kirmani and Rao, 2000).
However this paper will only focus on addressing ‘adverse selection’ side of information asymmetry, which is solved by sending signals to (potential) investors.
Concluding the logic of Elitzur and Gavious (2003), Kirmani and Rao (2000), and Stiglitz (2000), the quality of companies does not change once investors understand the current state of quality.
Although it still remains one of the prime barriers in capital markets. In capital markets, whether it is in public equity financing or private equity financing like VC financing, the occurrence of this information asymmetry can be particularly alarming. Asymmetrical information between investors and companies may clout the market value of that company (Healy and Palepu, 2001;
Brealey, Leland and Pyle, 1977). The basic idea is that entrepreneurs and top management teams presumably hold better knowledge about their companies’ values and tend to overstate those values (Akerlof, 1970; Stiglitz, 2000). This could lead to mis-valuation of a company’s value, thus would potentially disrupt the functioning capital markets. Healy and Palepu (2001) exemplified by stating that when investors fail to distinguish the ‘bad’ and ‘good’ ideas
(companies), it would result in investors valuing both ideas on an average level, thus lead to under-valuation of the ‘good’ ideas and over-valuation of the ‘bad’ ideas. Kreps (1990) further added due to this mis-valuation, there is a strong demand for financial and information intermediaries such as banks venture capitalists, financial analysis, news agencies, and rating agencies to overcome entrepreneurs and top management teams’ information prevalence.
For small ventures, Butler et al. (2007) stated, small ventures may not be required to disclose some specific firm information publicly, as contrast to companies in public equity financing where information disclosure is tightly regulated. In addition to having nascent organizational history, information asymmetry tends to be higher than those of larger more mature companies in public market. In equity crowdfunding, information asymmetry between investors and entrepreneurs is arguably higher than both in VCs financing and public equity financing. Venture capitalist can overcome information asymmetry by undertaking a tighter screening and evaluation process with direct communication with the ventures. However the means of communication between potential investors and is almost exclusively through crowdfunding platforms. Screening process is in fact first conducted by the platforms. Platforms typically require standardized documents such as business plans or financial forecast for ventures to be presented on the campaign page. However I noted not all platforms obligate ventures to publically present these documents, some platforms allow venture to have its preference on presenting document such as business plan publically, or privately by providing direct contact information instead. This however does not change the fact that potential investors still possess limited ability to evaluate their potential investments. Although many crowdfunding platforms actively involve in screening and evaluation process, they pose gap between investors and ventures such as the lack of imperative information to estimate likelihood of a venture success such as abilities of the management team. It would be rather difficult, especially if the venture is a start-up, to estimate its future state. For comparison, venture capitalist sometimes involve heavily in operating process and act as an experienced consultant rather that a mere financial provider. Investors’ inability to control their investment (Belleflame et al., 2015) may further pose treat to investors. For example depending on the type of contracts that investors and ventures sign on, because of communication-related factor between both parties, and the lack of public information exposure (as opposed to public equity financing), investors may lose control on how ventures would spend their money. Though Hagedorn and Pinkwart (2016) noted some contracts may require ventures to constantly update investors regarding their activities. Further, the lack of experience for amateur investors (which accounts a large number of people in crowdfunding platforms) may
result in them entering into the market in high default risks. However, this will not be discussed in the study.
To overcome this adverse selection, entrepreneurs and top management teams must send related information to their (potential) investors. One possible solution is signaling. The following sub- chapter will extensively explains the concept of signaling as the results of information asymmetry.
2.4 The Theory of Signaling 2.4.1 Definition
Previous chapters delved into theories behind CF concept and integrated it with current real world situation, followed by the introduction of information asymmetry concept. This sub-chapters discloses signaling theory as the background of this paper’ main research problem. Informational differences between investors and entrepreneurs occur as investors may hold less knowledge about a project or a company. This asymmetrical information is the results of managerial failure to deliver the intended information about a company’s values to potential investors. Consequently managers and entrepreneurs must try to disclose information that can address its value to potential and current investors. However the degree to which investors perceive this intended information about ventures’ values and the ability of managers and entrepreneurs to deliver their intended information are varied. Subjectivity of investors may further complicate this information to be conceived as valued. These assumptions are backed by the theory of signaling. Signaling theory was first theorized in the early 1970’s with the publishing works of Arrow (1972) and Spence (1973), of which its applications are now subject to various other fields such from corporate communication (Danielli, Bini, Giunta, 2013) to anthropology (BliegeBird et al., 2005). The work of Spence (1973) as one of an introductory paper of signaling theory, which provoked numerous precedent papers in various fields, differentiated job market for potential employees that are prospectively ‘high’ quality and ‘low’ quality by looking at their educational levels.
The base of signaling theory concerns about minimizing asymmetrical information between two involved parties (Spence, 2002). There are several elements that are part of the signaling theory.
Firstly, the senders of signals, who are those insiders of companies that posses the knowledge and information of organization, products, or individual that outsiders do not possess (Connelly et al., 2011; Spence, 1973; Ross, 1977). Secondly, the signal receivers or outsiders (e.g. potential
investors, customers) are also crucial elements in signaling theory. (Potential) Investors as the receiver of signals could alienate the meaning of signals from entrepreneurs’ or managers’
intention as its receptivity depends on receivers’ individual experience, knowledge, and abilities (Ndofor and Levitas, 2004). The other element is signal features, as signaling theory focuses on communicating imperceptible, and positive quality features of insiders to outsiders (Connelly et al., 2011).
Busenitz et al. (2005) defines signal as information that could potentially alter the understanding of a future state. While Kirmani and Rao (2000) delineated signals as ‘observable attributes’ from individuals that could transfer information or change the beliefs of other individuals about intention and ‘unobservable features’. ‘Unobservable features’ as explained by multiple scholars including Connelly et al. (2013), Janney and Folta (2000), Kirmani and Rao (2000) mean that prior signals transfer, information about some ‘insiders’’ values are unknown or ‘unobserved’ to
‘outsiders’, thus it is communicated through many forms until these hidden abilities are revealed or ‘observed’. Example of ‘unobservable features’ by outsiders that insiders posses are early- research projects and pending lawsuits. This information is ‘unobserved’ by investors until the companies disclose them. Nonetheless, not all information can be used as signals with some may even negatively impact for the underlying value of the companies.
Existing papers on signaling theory often use the term ‘quality’ to differentiate the ‘good’ and the
‘bad’ signals. As quality is often attributed as a separating characteristic that can be interpreted in many different ways (Connelly et al., 2011), managers then must carefully consider which information to be released as signal. For example, releasing design plans or prototype may send positive signals to potential investors regarding the companies’ knowledge quality (Audretsch et al. (2012), while at the same time exposing them to appropriation of knowledge by competitors (Ndofor and Levitas, 2004). Quality signals in the eyes of investors should therefor be difficult and costly for other companies to imitate (Folta and Janney, 2006; Keasey and Short, 2010).
Additionally, information asymmetry among investors can result in investors’ failure to distinguish higher quality companies with those of lower quality. Consequently, investors may then over-value ‘lower’ quality companies and under-value ‘higher’ quality, making lack of resources for these higher quality companies for growth (Healey and Palepu, 2001; Brealy et al., 1997; Spence, 1974).
Connelly et al. (2011) refers quality signals should have two main characteristics, namely signal observability and signal cost. Oberservability represents the extent to which potential investors can receive the signals (Connelly et al., 2011). Because even though quality signals can be transferred in many forms, investors as the receiving end of signals are the ones who will observe and interpret them. Likewise, signal cost is another essential characteristic of quality signals as explained by Connelly et al. (2011). While the first one focus on the signal receiver, the later weights more for competitors. Signal cost is referred as the cost associated to imitate signal, as managers or entrepreneurs of ‘higher quality’ holding better value should be able to send signal less costly.
2.4.2 Signaling in public equity financing
Levy and Lazarovich-Porat (1995), claimed that it is near impossible to empirically test signaling theory in other areas due to inability to hold all variables constant (e.g. preconceived notions and characteristics of investors). Nonetheless, there have been extensive amount of literatures documented how financial and non-financial information are used as a signals of potential stock return. It is a well-known fact that investors’ activities on trading floor are largely influenced by information released about listed companies. For example, financial information such as past financial activities (Healey and Palepu, 2001), corporate debt (Barclay and Smith, 1995), financial ratios (Lewellen, 2004) and accounting disclosure rules (Bertomeu and Magee, 2015) have traditionally been used as indicators of signals to investors. However substantial amount of literatures found that even though financial information is highly over-looked, non-financial disclosures represent highly informative sources that could potentially be looked as positive (negative) signals about future state of companies by investors, especially when they are combined with financial information (Amir and Lev, 1996; Danielli et al., 2013). Large number of literatures had their focus on certain source of non-financial information such as board members structure (Certo, 2003; Cohen and Dean, 2005), and strategic alliances partners (Stuart, Hoang, and Hybels 1999). Certo (2003) found board members reputation to be positively correlated with share price performance, especially during IPO. While Certo et al., (2003), and Stuart et al., (1999) found that companies going for an IPO to pay premium price to work align with reputable auditors and investment banks. Companies’ willingness to pay premium for reputable investment banks prior IPO emphasized Connelly et al.’s (2011) main characteristics of signals to be its observability and costly, as reputable investment banks and auditors are reluctant to align with companies of ‘lower quality’ (Folta and Janney, 2006).
2.4.3 Signaling in VC financing
For young ventures in both EC and VCF, transfer of signals could potentially be intricate especially during the early stages of financing. Compare to public equity financing through an IPO, VCF frequently requires multiple stages of examination and evaluation before VC’s final decision process. Busenitz et al. (2005) pointed out the importance of signals during the early screening, valuation, and due diligence process of VCF, with the later often involves in evaluating tangible and intangible assets. However, Baum and Silverman (1999) expressed that even though the process takes time, alignment with a well-established VCs can overshadow young ventures’ liabilities of being small and inexperience while gaining valuable access to knowledge and capital. Subsequently, Folta and Janney (2006) found that involvement of reputable VCs to be an effective signal for (potential) investors, showing that strategic alliance as asserted by Certo (2003) and Stuart et al. (1999) within equity financing also applicable in VC financing. Ndofor and Levitas (2004) gave an example on strategic alliance of a new venture with a key external partner would increase the chance of it being attractive to others.
As the capital market of small young ventures is not as highly regulated as those in public equity financing, entrepreneurs have relative freedom on what kind of information they regard as
‘quality’ signals to be send to VCs. Nonetheless, some literatures including Alveraz and Busenitz (2001) expected it to be unrealistic for entrepreneurs to transfer all information they possess, as leaking some unfavorable information could potentially jeopardize the entire funding process and increase the cost of equity (Alveraz and Busenitz, 2001; Busenitz et al., 2005). Folta and Janney (2006) argued that as environment constantly changes, increasing signal frequency by delivering more observable signals and boosting the number could improve effectiveness, Balboa and Marti (2007) added repetitive signals of same message via different channels enhances its effectiveness.
On the other hand, Fischer and Reuber (2007), and Gao et al. (2008) argued sending multiple and conflicting signal would only confuse them. Nonetheless, as in equity financing, signaling is also highly importance in VC financing. Entrepreneurs are likely to transfer more information to VCs as VCs are much more involved in young ventures developments compare to individual and organizational investors involved in equity capital market.
2.4.4 Signaling within equity crowdfunding
As an evolving and developing field, there is still a lack of academic literatures exploring EC in general. Nonetheless, there are some empirically tested literatures such as Hagedorn and Pinkwart (2016) on financing process of EC, Turan (2015a) on stakeholders’ risk, and Ahler et al. (2014) on signaling.
Signaling in EC is more challenging compare to that in public equity financing, since communication is almost exclusively made online and entrepreneurs have limited capabilities to interact with (potential) investors. This is the main difference between signaling in EC and public equity. Thus asymmetrical information is likely to be higher than in public equity market. An example from strategic alliance, many literatures have expressed that having strategic alliances with reputable investors, investment banks, venture capitalists, and creditors are seen as quality signals to (potential) investors particularly prior an IPO. However such strategic alliance may not available for entrepreneurs raising capital through, as they are most likely to be first-time entrepreneurs (Vismara, 2016). The first round of financing has arguably been crucial for new ventures not only for growth resource, but also a determinant for the subsequent financing rounds, the involvement of experienced investors during the first financing round might overcome the lack of strategic alliances with reputable intermediaries. Folta and Janney (2006) have indicated that professional involvement increases the chance of ventures’ ability to attract more capital injection in subsequent financing rounds. Moreover, in public equity financing, information is rather easily obtainable. For example any information especially for big companies can be released by many sources including company’s press releases, news reports, journalists of various media, rating agencies, stock market reports. In equity crowdfunding, investors only rely to information provided during the ‘Roadshow’ (refer back to financing process on chapter 2.1.3).
When referring to signaling in VCs financing, though both types of financing involve private investors and small ventures, private investors in EC practically have very limited role once ventures have accumulated the capital. VCs is known to be involved not only in providing capital, but also management roles and usually require strict screening, evaluation, and due diligent process. It could also potentially be harder for investors to conduct due diligence to confirms all facts provided in platform page as it involves evaluating tangible and intangible assets of the ventures whereas investors may only be left with ‘soft’ information provided in the platform page.
Concluding remarks
Outlining all the abovementioned papers, as although EC is expected to grow considerably in the future, it is apparent that signaling theory is an eminently important aspect of equity-based crowdfunding and more research will need to be done in this field. The likely higher presence of asymmetrical information between entrepreneurs and (potential) investors and limited
communication capabilities making signaling in EC more challenging than that in public equity market. Following several papers investigating signaling theory (Busenitz et al., 2005; Connelly et al., 2013; Kirmani and Rao; 2000) this paper defines signal to be any information released by the entrepreneurs for (potential) investors that could possibly change (potential) investors view of the future state of the business. While following Connelly et al.’s (2011) comprehensive review on several signaling theory papers, to define ‘quality’ as “unobservable ability of signaler to fulfill the demands of an outsider observing the signal” (Connelly et al., 2011).
The following chapter develops hypothesis based of several information that have been empirically tested as signals in public equity and venture capitalist financing that can be associated in equity crowdfunding. This chapter then followed by methodology and data used to empirically test the corresponding hypothesis.
Chapter 3: Hypothesis Development
Previous chapter argued how asymmetrical information between (potential) investors and entrepreneurs/managers exists in both conventional and alternative financing. Signaling theory was developed to overcome this issue. I have defined what signal is and which signal could be seen as ‘quality’ signal. However as only a handful of literatures have empirically tested this theory within equity crowdfunding, the extent to which types of signals could potentially be prominent for entrepreneurs’ funding success in ECP is still obscure. This chapter will argue certain types of potentially influential signals based on empirically tested signaling theory literatures from conventional and venture capitalist financing. Subsequently, hypothesis is to be developed at the end of the chapter.
Based on available literatures, I formulated several types of these signals into 5 categories.
Namely (1) Intellectual Property (Audretsch et al., 2012; Baum and Silverman, 2004; Hoenen et al., 2014; Ndofor and Levitas, 2004), (2) Human Capital (Baum and Silverman, 2004; Certo, 2003; Davidson and Honig, 2003; Shane and Cable, 2002; Spence, 1973), (3) Social Networks (Belliveau, O’Reilly, Wade, 1996; Lin et al., 2013; Ghoshal and Nahapiet, 1998; Ndofor and Levitas, 2004; Stuart et al., 1999), (4) Financial Information (Barclay and Smith, 1995; Bertomeu and Magee, 2015; Danielli at al., 2013; Healey and Palepu, 2001), and (5) Other Non-Financial Information (Cassar, Cavalluzzo, Ittner, 2015; Deephouse, 2000). It is expected that each category will positively influence funding success of a venture in equity crowdfunding. The relationship between each signal category is depicted in the following figure:
Figure 3
Now I will argue the relevance of each category on funding success on EC along with each corresponding signals.
3.1 Intellectual Property
Intellectual property is one of the most valued attributes of a venture. It is crucial for a company regardless its age to keep innovating in order to maintain their competitive position among their competitors and to sustain its growth and survival (Stuart et al., 1999). Naturally speaking, entrepreneurs and managers need to show to their stakeholders that they are able to innovate.
Investors as outsiders may not know companies’ internal innovation process such as early- research projects or early product development especially for young ventures (Kirmani and Rao, 2000), however entrepreneurs can show this by, for example, applying a patent or demonstrating a product prototype. Based on related literatures, I limit the extent of intellectual property definition into ownership of patent.
It is a well-known fact that ventures are racing to innovatively produce outputs from their R&D’s departments. Blind et al. (2006) noted that R&D process has increasingly become specialized since 1990s, directing ventures to be more differentiated in their R&D process, thus leading to higher number of patented inventions especially in tech-related industries. A patent gives the venture a legal right to exclusively use its patented invention(s) against the used by their competitors and/or other unauthorized individuals. The motives of patenting itself have significantly varied from its traditional intention of offensive blockade (prevent others to use) to increase reputation and image of the venture, give higher negotiation leverage to its stakeholders,
